Keynesian versus Classical by Mark Susor

Discussion The Discussion: “Keynesian versus Classical,” refers to two economic models used to understand and measure the economy. The Keynesian Model or “view of the macro economy [,] emphasizes the potential instability of the private sector and the undependability of a market-driven self-adjustment [,]” (Hill, Schiller, & Wall, 2013, p. 199) also known as the Classical Model or market-driven macro economy. The “Keynesian theory is the most prominent of the demand-side theories. Keynes argued that a deficiency of spending would tend to depress the economy. This deficiency might originate in consumer spending, inadequate business investment or insufficient government spending” (Hill, Schiller, & Wall, 2013, p. 170). The Great Recession of 2008 is the most recent example of using the Keynesian theory to address an economic imbalance in the US macro economy. The 2008 recession was created by a lack of consumer demand which shifted the aggregate demand curve to the left. In reaction to the drop in demand, President Obama’s “first major intervention was a massive fiscal policy package of increased government spending and tax cuts—the kind of policy Keynes advocated” (Hill, Schiller, & Wall, 2013, p. 174). The weak demand was triggered by the housing bust and the resulting foreclosures, falling home prices, financial crisis, collapse of the credit markets, drop in the investment markets, closing of auto plants; which resulted in the highest unemployment in 35 years. The drop in home prices during 2007 led to a fourth quarter drop of 29 percent in residential investment which drove U.S. investment down by $50 billion. This was the beginning of the recession and what can be called the multiplier process. Keynes not only rejected the classical notion of self-adjustments; he also argued that things were likely to get worse, not better, once a spending shortfall emerged….Cutbacks in investment spending in 2007-2009 led to layoffs among homebuilders, mortgage companies, banks, equipment manufacturers, auto companies, and even high-tech companies like Hewlett-Packard, IBM, Yahoo!, and Google” (Hill, Schiller, & Wall, 2013, pp. 212, 214). This led to the multiplier process which states that “a decline in investment reduces consumer incomes, and induces cutbacks in consumer spending. The resultant [investment] decline in consumption triggers further declines in income and spending [on the part of the consumer]” (Hill, Schiller, & Wall, 2013, p. 215). This could be seen in the fourth quarter of 2008 when gross domestic product (GDP) declined by 3.8 percent after incurring a 0.5 percent drop in the third quarter. As a result of the leftward shift of the aggregate demand curve, the equilibrium level of real GDP fell below the full employment level, thus the recession. President Obama chose the Keynesian approach to fixing the demand curve, because he ran for the presidency by promising to change the economy for the better. He took an activist policy approach, as he felt he could not wait for the do-nothing approach and let the economy self-correct using the Classical Model (Hill, Schiller, & Wall, 2013, p. 174). President Obama’s stimulus spending package is known as The American Recovery and Reinvestment Act of 2009 which provided federal spending on onetime infrastructure investments, safety net programs that included expanded unemployment benefits, Medicaid, and food stamps as well as tax cuts. “The [government stimulus] package was intended to shift the [US] aggregate demand curve to the right” (Hill, Schiller, & Wall, 2013, p. 234) spurring consumer spending and business investments; which in turn would create jobs. While these fiscal policies helped to stop the economic free fall of 2008, they were not sufficient enough to bring the US economy back to prerecession levels. In fact, five years after the recession began; December 2012, the US “unemployment rate [still] stood at 7.8 percent—more than three percentage points above the annual rate in 2007….national output was roughly $1 trillion below what it could have been if the economy were at full employment. Furthermore, as of December 2012, 9.1 million jobs [were still needed] to be created [in the US economy in order] to restore prerecession labor market health” (Bivens, Fieldhouse, & Shierholz, 2013). The main driver behind the current unemployment rate has to do with a slow recovery from the great recession. Overall unemployment in the US has improved from 85. to 6.6 percent within the last year. Labor force participation rates have fallen slightly from 63.3 to 63.0 percent. Unemployment amongst men has improved from 9.0 to 6.8 percent while participation continues to drop from 69.7 to 69.3 percent. When looking at unemployment amongst women we find the best picture with unemployment improving from 7.7 to 6.7 percent with participation dropping from 57.9 to 57.1 percent. Teenagers continue to reflect high unemployment, but show the largest improvement from 23.7 to 21.4 percent. Current unemployment remains high compared to the governments full employment goal; “the lowest rate of unemployment compatible with price stability, variously estimated at between 4 percent and 6 percent unemployment” (Hill et al, 2013, p. 125). Slow US economic growth is reflected in Real GDP (Gross Domestic Product) growth rates that have fallen from 2.8 percent in 2012 to a forecast of 1.6 percent for 2013. Retail sales growth has declined from 4.7 percent in 2011, to 3.1 percent in 2012 and is forecasted to come in at 2.7 percent in 2013. IP (Industrial Production) growth has also declined from 4.8 percent in 2011, to 4.2 percent in 2012 and is forecasted to come in at 2.3 percent in 2013. There has also been a decline in export and import growth. Exports growth rates have fallen from 7.2 percent in 2011, to 3.8 percent in 2012 and are forecast to come in at 2.0 percent for 2013. Imports have fallen from 5.3 percent growth in 2011, to 2.1 percent in 2012, and are forecast at 1.4 percent in 2013 (Bayann, 2013 & Traub, 2013). The slow recovery has been impacted by repeal of the Bush tax cuts, implementation of budget sequestration, and the ongoing battle over the National Debt which has risen from $9 trillion to almost $17 trillion under President Obama. The repeal of the tax cuts pushed the consumption demand curve to the left, while sequestration reduced government spending, also pushing the aggregate demand curve to the left. Due to ongoing high unemployment the Federal Reserve has continued to adhere to a monetary policy that keeps interest rates low and also uses quantitative easing to further stimulate investment. Even with the quantitative easing, inflation has been maintained close to 2 percent and there has been no signs of deflation or hyper-inflation as of yet. Overall, the Keynesian policies have failed to have the impact President Obama had hoped for, but at the same time the policies have been hindered by the budgetary fights and the resulting austerity measures. A proper approach would have been to use the initial stimulus package to stop the free fall, but then to create demand through tax cuts, low interest rates, reduced government regulation, and bipartisan budgets that worked toward a long-term balanced budget policy, thus stimulating growth, and thereby increasing tax revenues and driving business investment and consumer spending. References Bayaan, I. (2013, September 30). US Economic Update. UPS Planning and Forecasting Publication. Bivens, J., Fieldhouse, A., & Shierholz, H. (2013, February 14). From free-fall to stagnation: Five years after the start of the Great Recession, extraordinary policy measures are still needed, but are not forthcoming. Retrieved from http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/ Hill, C., Schiller, B. R., Wall, S. (2013). THE MACRO ECONOMY TODAY. In B. Gordan & S. Smith. (13th. ed.), (pp. 170-214). New York, NY: McGraw-Hill/Irwin.